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Disputations: Our New Theory Of Macroeconomics

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In his review of our book Animal Spirits (“Shorting Reason”; April 15, 2009), Richard Posner questions the book’s basic premise, which is that we cannot understand the current economic crisis without appreciating inconstancies of human thinking. He asserts that everything that has happened in the last two years could be explained as due to honest “mistakes” that are at worst the “result of limited information.”



His view is certainly consonant with the prevailing view among academic economists who practice macroeconomics. The canonical paradigm that is taught to new Ph.D. students all over the world today is that people are like computers in the processing of information: They analyze all exogenous processes that impinge on the economy, break down the processes into statistical noise that is propagated through known impulse response functions, and calculate and implement their optimal response using dynamic programming. As a result, speculative markets are perfectly efficient and prices change through time only as a result of objective new information.



It is of course absurd to imagine that people literally do such elaborate calculations, but the academic leap of faith has been that somehow people behave as if they do such calculations. Unfortunately, the daring of this leap of faith has largely been forgotten by economic theorists, who, after decades of such thinking in the literature, have the complacency to assume that these models are safely established and decorous.



When Posner asserts that it is not always easy to rule out that people are acting rationally--even if they seem not to be--he is of course right, for this is what most academic economists have thought. It is hard to disprove such a theory that people are completely economically rational because the theory is somewhat slippery: It doesn’t specify what objectives people have or what their information really is.



But it is precisely this view which we believe underlies the complacency that brought on this crisis. Why didn’t we see this coming? We didn’t because we were cowed by an economic theory that has reached too high a level of academic consensus.



We didn’t appreciate the accelerating bubbles in the stock market and the housing market because we had an economic theory that denied that such bubbles even exist.



One of us (Shiller, along with colleague Professor John Campbell of Harvard) stood before Alan Greenspan and the entire Federal Reserve Board in December 1996 and testified that the stock market was being blown into what seemed to be an irrational bubble. Three days later, Greenspan made his famous “irrational exuberance” speech. But Greenspan did not continue to raise the possibility of a developing bubble in stock prices for very long. For one thing, a Fed chairman is generally expected to be a booster of confidence, not a bear.



Later, when Greenspan failed to take actions that might have slowed or stopped a bubbles in the stock and real estate markets from developing, he likely felt confident that his decision was supported by the well-established, mainstream thinking of the economics profession. Throughout the profession, a conventional wisdom had emerged that the stock market was soaring because rational economic actors must be foreseeing a dramatic new economic era. The honest “mistakes” that policy makers made, in keeping credit too loose and delaying other countercyclical measures during a historic stock market and housing bubble, were really due to that conventional wisdom.



It is these core ideas of economic theory that we are challenging in this book, and these core ideas are going to be difficult to dislodge.



Posner makes the interesting point that most behavioral economists--who study the application of psychology to economics--did not predict the economic crisis either. We would put this somewhat differently: There were very few behavioral economists who made forceful public statements that a crisis may be imminent. That is because there are very few behavioral economists who even specialized in macroeconomics, and so virtually none was willing to take the risk of making any definitive forecast. There has been a curious lack of interest by economic researchers in behavioral macroeconomics, something that we have sought to correct through our series of seminars on behavioral macroeconomics since 1994, and through this book.



The role of irrational behavior in the macroeconomy is not trivial and obvious to see. It requires the development of a new theory, which we only just have begun to provide in our book. In this book we strove to put together an array of evidence, some of it from psychology, some of it from economic research, that gave an overall picture that we think is in stark contrast to the usual paradigm. It is a picture that stresses factors that are totally absent from conventional macroeconomic theorizing: that the economy is affected by variations in the level of trust, by storytelling and human interest, by perceptions of corruption or unfairness, by anger and optimism, by social epidemics causing changes in gut instincts and feelings. Those factors, we firmly believe, are ultimate causes of the boom we saw a few years ago, and the bust we are seeing now.



Posner also questions whether we are right to interpret Keynes as suggesting that animal spirits are a major driver of the economy. Keynes certainly did think that speculative thinking was not inherently about the “new information” about fundamentals that modern macroeconomic theory supposes, as his famous “beauty contest” parable (describing stock market investors as if they were participating in a contest to select from a group of photos the faces that others think are prettiest) shows. But we cannot say definitely to what degree Keynes would have been sympathetic to our view. Nor does it really matter what he would have thought. We are presenting a theory of macroeconomics which we think is in the spirit of Keynes, but it is a new theory.



Click here to see Posner's response to this piece.


George A. Akerlof is the Daniel E. Koshland Sr. Distinguished Professor of Economics at the University of California, Berkeley. He was awarded the 2001 Nobel Prize in economics.


Robert J. Shiller is the best-selling author of Irrational Exuberance and The Subprime Solution (both Princeton). He is the Arthur M. Okun Professor of Economics at Yale University.

By George A. Akerlof and Robert J. Shiller

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